The future of over-the-counter markets lies in standardization, according to Dan Smalley, head of derivatives business development at trading platform provider Fidessa.
“The OTC market is becoming more standardized," Smalley said. "The whole idea for the regulators is to take this very opaque world of OTC and make it more transparent, and to take away the risk inherent between bilateral uncleared contracts.”
Smalley will speak at Markets Media’s Chicago Trading & Investing Summit on Sept. 23.
In the listed futures market, standardization is present in the form of exchange-traded derivatives and central clearing. "There's a very clear idea of what the positions are between the different counterparties at the CCP,” said Smalley. “The view is that a good portion of the products which trade OTC right now will trade in a much more standardized way.”
Smalley has spearheaded Fidessa’s efforts in futures markets. “Over the last nine years, we've been very successful in focusing in on a strategy to provide agency-style access and all the tools around agency-style trading for a large number of FCMs like Citibank, Newedge and Nomura,” he said.
One of the consequences of the evolving OTC paradigm is there is no longer a direct linkage between execution and clearing venues, which necessitates changes in the workflow used by clearing brokers, swap execution facilities, and buy-side users to accommodate multiple trading venues, mandatory clearing and pre-trade credit checks.
“At the moment in the futures space, there is a vertical clearing model, where you've got a clearinghouse associated with the exchange,” Smalley said. “With the advent of cleared swaps, you can have a situation where you trade on one SEF but you can clear at the CCP of your choosing. They’ve broken that vertical clearing model.”
He continued, “If you trade on an individual SEF, then you can choose whether you clear LCH SwapClear or CME or Ice, which is different from the world of futures. If you traded a CME mini-S&P future today, you would have to clear it with the CME. You can't go and clear it somewhere else.”
FCMs, as the clearing members of CCPs, have a stake in the development of the OTC clearing model.
“The impact is they have to make a decision whether or not they're going to be active in that space,” said Smalley. “If you've got a buy side firm that trades both swaps and futures, then there's an expectation that you will clear and execute both of those asset classes. The pressure is on the FCM to be able to provide the services that the market needs but whether a viable commercial model exists is still yet from certain ”
Although many of the SEFs today operate on the traditional request for quote model, the market is evolving toward exchange-like features such as resting liquidity and limit order books.
“It’s also having dealers quote dynamically within those limit order books,” said Smalley. “To shift the market from RFQ to actually having streaming liquidity, whether it's from the buy side or whether it's from the dealers.”
Assuming this happens, the need will arise to aggregate liquidity across multiple SEFs. Tier one firms have built their own SEF access/aggregation tools, like Morgan Stanley’s Matrix and UBS’ Neo. “The platforms provide swap access to SEFs alongside futures and fixed income, but it's a big investment to go and build a platform that will connect to all the SEFs,” said Smalley.
